Gaps: technical analysis indicator to power your trade
Who doesn’t like surprises? Perhaps markets don’t.
As soon as there’s a surprise for them, they react overzealously.
And when they react fanatically, gaps are formed.
And when gaps are created or filled, that becomes an important indicator for traders and investors.
What are gaps?
In technical analysis, when no trade takes place between two price points that creates a gap.
Gaps have a special significance as they represent gaps in the understanding of investors. Gaps usually take place to incorporate a sudden spurt of information in prices which wasn’t known to the market so far and hence, wasn’t factored in.
On February 27, 2020, Sensex hit the low of 39,423 and the high on February 28, 2020 was 39,087. Moreover, the open and high of 28 February, 2020 were the same. In other words, no trade happened between 39,423 and 39,087 which created a gap of 336 points. This gap never got filled thereafter.
A gap is created when:
1. Day’s low is higher than the previous day’s high—Bullish indicator
2. Day’s high is lower than the previous day’s low—Bearish Indicator
Weekly and monthly readings of indices/stocks can also create gaps.
What kind of information?
1. A company reported 25% profit growth which was better than analysts’ estimates and also above the industry average, or vice-a-versa.
2. Natural calamity which looked like a domestic problem of a country suddenly spread to other countries thereby endangering the global growth.
3. Unexpected election outcome that changed a country’s political equations completely.
The above are just a few examples and that’s not an exhaustive list.
It’s noteworthy that there may or may not be visible fundamental changes when a stock or an index trades with a gap. Stock markets are forward looking so visible changes in fundamentals may follow later.
Why should you follow gaps?
Gaps represent strong support or resistance depending on the price movement of the stock. In short, you can’t make out anything from gaps unless you know the underlying price trend on Daily/weekly/Monthly charts.
Types of gaps and their interpretations with examples
Common Gaps: Common gaps occur in sideways price patterns like rectangle, triangle or wedge amongst others. They aren’t of much importance and don’t indicate anything substantial about future price movements. As a result they get filled within a few trading sessions as the underlying trend is still sideways.
For instance, the chart above suggests a common gap came about when the low of January 16th was higher than the high of January 17th. But the sudden spurt of information wasn’t strong enough to move the underlying price trend.
Breakout Gaps: A breakout gap is formed when the underlying trend changes from sideways to bullish/bearish due to an upward/downward gap created by a sudden rise/fall in the price. These gaps offer powerful signals and usually take a long time to get filled, especially when coupled with a huge rise in volume.
Such gaps usually indicate that a faster and sharper price movement may follow in future. When you are comparing two breakout trends (either upward or downward)—one with a gap and one without any gap, the former is considered stronger and more dependable than the latter.
In the chart above, Titan experienced a downward breakout gap on March 12th as the high of that day was lower than the low of previous day. This gap down movement happened after the stock had been trading sideways for nearly 10 weeks. On the day of the gap down, a big red candle was formed and was also followed by a further drop in price on the following days.
After staying in the congestion area for 10 weeks, the stock fell sharply with a gap down trade which suggests investors thought there were no triggers to take the prices up but there were enough triggers to drag the prices down.
Runaway Gaps: These gaps occur when prices either rise or fall sharply after forming the initial gap. Runaway gaps indicate rising interest in the scrip and continuation of the pattern initiated. Traders and investors who miss the trend initially get active subsequently, resulting in the accentuation of the trend. Rallies and declines are almost vertical and strong.
As depicted in the chart above, between March 6th and March 12th, Vedanta fell sharply from Rs 108 to Rs 85.5 by forming runaway gaps on the downside. Even at the time of writing, these gaps remain open.
Exhaustion Gaps: They are difficult to identify and usually happen after a long or sharp up or down move. Exhaustion gaps may also be followed by runaway gaps on the upside or the downside depending on the established trend. In other words, the exhaustion gaps denote profit booking and also exhaustion of a trend. They are experienced near the top or the bottom and suggest that the reversal in trend is likely. Since exhaustion gaps are difficult to identify, one should wait for a clear and more pronounced indication to trade the trend reversal.
In the chart above, profit taking has given rise to an exhaustion gap but the trend reversal confirmation hasn’t come yet.
Gaps represent surprise—positive or negative, depending on the type of gap. They represent a sudden rise or fall in investor interest, followed by price action of an index/stock. But one can’t make anything out of gaps in isolation. Underlying trend and duration of the trend usually provide additional information about the likely strength of a gap. The right interpretation of gaps helps you trade and invest smartly.
Gaps that denote reversals after a sharp rise or fall usually indicate a new wave of accumulation or distribution. The key to trading and investing success is not to get caught on the wrong side of these accumulation and distribution cycles.
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